Winter 2023 Survey

Interest Rates and Recession Concerns Are Weighing on Commercial Real Estate

Jerry Nickelsburg
Adjunct Professor of Economics, UCLA Anderson School
Senior Economist and Director, UCLA Anderson Forecast

The level of uncertainty in the economy has elevated dramatically in the months since the Summer 2022 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey. The combination of recent Federal Reserve interest rate increases and an increased possibility of a near-term recession has resulted in more challenging commercial real estate financing including a demand by financiers for higher equity participation and higher rate of return hurdle rates. Nationwide, a contraction in new commercial development is now underway. The latest Survey, taken in December 2022, coupled with analysis by the UCLA Anderson Forecast, paints a relatively better picture for commercial real estate in California. This is particularly true for the period after 2023. Nevertheless, commercial real estate development in California is also impacted by higher interest rates and the expected slower economic growth.

Statistical forecast analysis has as its basis the proposition that past statistical relationships hold into the future. A knowledge of those correlations, current data and perhaps some assumptions about data not yet known, lead to the forecast. Though data over the past six months show underlying strength in the California economy, the response to the growing uncertainty about the 2023 economic outlook are clearly present in the Winter 2023 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey. The Survey has a rich set of questions such that, with past trends in the Survey’s indexes, we can now infer a more nuanced turn in commercial real estate markets.

The Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey compiles the views of commercial real estate developers, owners, and investors with respect to markets three years hence. The three-year time horizon was chosen to approximate the average time a new commercial project requires for completion (though projects with significant entitlement and/or environmental issues often take much longer). The panelists’ views on vacancy and rental rates are key ingredients to their own business plans for new projects, and as such, the Survey provides insights into new, not yet on the radar, building projects and is a leading indicator of future commercial construction. For example, if a developer were optimistic about economic conditions in Silicon Valley’s office market in 2025, then initial work for a new project with an expected ready-for-occupancy date of 2025 — a business plan, preliminary architecture, and a search for financial backing — would have to begin no later than the latter part of 2022.  Although optimism does not always translate into new construction projects, this sentiment is usually a prerequisite for it.

Office Space Markets


For developers of office markets, the rationalization of existing office space and a return to the office are key elements in deciding where and when to invest. One year ago, sentiment turned positive as developers were seeing the beginning of a return to the office and that view continued through the summer. Now, that sentiment has waned and in each of the eight markets surveyed it has turned or remained negative (Chart 1). On average, participants in each panel expect both rental rates and occupancy rates to weaken in the coming year and not fully recover to current levels by 2025. This portends less new office construction, particularly in the year to come (Chart 2).

Prior to the Winter 2023 Survey, the prediction for Northern California was for demand to grow at least as fast as supply largely due to optimism on the part of the Silicon Valley panelists. At that time nearly 50% of the Northern California panelists were planning at least one new office development. With the reorganization and downsizing of large tech firms, that has now reversed.  In the latest Survey, the percentage of panelists planning new development is down in the low 20% range. Moreover, that 50% expectation from a year ago did not materialize with developers pulling back throughout the year.

Why the turnaround? It is not because office-using employment is shrinking. Over the last year Bay Area office-using payroll employment grew by 3.8% and it has grown at an annual rate of 5.0% the last three months. There are two related reasons that can explain this turn in sentiment. First, financial markets are demanding it with higher interest rates and more stringent lending conditions. Second is the fear of a recession. The pandemic years’ impact on office space has made developers cautious in the face of increased uncertainty. The possibility of a recession in 2023 has fed that uncertainty. This will change once workers are back in the office and the overhang of empty office space is worked off, but the Survey provides evidence that such a change remains a few years distant.

In Southern California, the panelists’ views are decidedly more pessimistic than in the previous two surveys (Chart 1). The aforementioned uncertainty has driven the sentiment index from positive to negative or negative to more negative in each of the four markets surveyed. Developers of SoCal office space are for the most part planning on staying on the sidelines for the next 12 months with only 29% currently planning new projects at this time (Chart 2).

The implication of these Survey results is that Federal Reserve policy, designed to cool the economy, has successfully done so for office space in California. The UCLA Anderson Forecast presented two scenarios of future Fed policy. In the first, the Fed continues aggressive increases in interest rates and there is a mid-2023 recession. In this scenario private office using payroll employment contracts by 2.5% from the fourth quarter of 2022 to the fourth quarter of 2023 and then grows by 1.4% by the fourth quarter of 2024. Were the Fed to moderate interest rate increases as in the alternative scenario, private office-using payroll employment grows by 2.8% in 2023 and continues to grow by 1.2% the following year. The higher financing hurdle plus the potential swing from -2.5% to +2.8% and the uncertainty about the rapidity of return-to-work explains the very pessimistic office development panels. Nevertheless, the recession, if it happens, is expected to be mild, and the uncertainty fueling a pullback in office development ought to abate by this time next year. Important for a return to growth is an understanding of the yet to be determined new amenity-rich office configuration, and the volume and rate conversion of some office space to residential and other alternative uses.

Chart 1
Chart 2

“When it comes to making major financial decisions, the current market conditions are still giving people pause, on both the owner/developer side and on the tenant side. Long term leases are still happening, but they tend to be with bigger companies, and in industries such as life science.”

— Julie Hoffman, Partner, Allen Matkins

Industrial Space Markets


In the commercial real estate realm industrial space has been the star performer of late. Though development has continued at a torrid pace, by all reports it has barely kept up with the market through the end of 2022. Over the past several years there have been consistently high occupancy rates and superior lease rate growth. Yet, the Winter 2023 Survey shows a decided drop in industrial space developer sentiment for three of the five markets surveyed indicating that markets three years hence will be worse than today (Chart 3). Normally this shift in sentiment would indicate a turning point in the market, and in a sense it does. Industrial markets throughout the state are overheated. Moreover, there remain a number of million square-foot warehouses currently under construction as developers have responded to demand levels that have pushed vacancy rates below 1% in both Los Angeles and the Inland Empire. At some point supply should catch up and when it does, vacancy rates will increase. It is this turn in the market that is indicated in the current Survey.

Chart 4 shows the demand and supply survey question responses for the past 4 years. A value over 50 indicates that the panels expect demand for space to increase faster than the supply of space during the three years following the survey date; a time frame that now spans today’s current recession worries. In the Winter 2023 Survey, developers expected demand to grow slightly faster than supply. To the extent that development is a bit greater than the increase in demand, the demand/supply gap will begin to close. As that happens, a more normal vacancy rate, one higher than today’s, will emerge.

In spite of more challenging financial conditions, a projected continuation of low vacancy rates and increasing rents allows developers to pencil out new projects. Two-thirds of the Southern California panelists are planning at least one new project in the next 12 months, and in Northern California 53% are planning on doing so. If there is no recession and income growth continues, then the predicted easing of these overheated markets could be delayed, and the pace of new development should then pick up.

Chart 3
Chart 4

“The many factors that keep the industrial market so hot today are low vacancy, high rent growth, lack of supply, and hard-to-find available land. All those things and competition are going to keep the market very strong.”

— Barbara Perrier, Vice Chairman, CBRE

Multi-Family Housing Markets


Even though rents have softened, the multi-family panels in five of the eight markets surveyed remain bullish about the coming three years. However, it is very much market dependent (Chart 5).  Similar to industrial space markets the real story is behind the headline numbers.  The Winter 2023 Survey panelists, in general, do not think that the market imbalance created by a shortage of affordable housing will end anytime soon. So, in spite of a more challenging financing climate, their plans are for more new projects in the next 12 months than they started over the previous year.

There are three markets where the composite sentiment index has moved from optimistic to pessimistic; San Francisco, Los Angeles, and the Inland Empire. For San Francisco the overriding factor is, as with office space, the uncertainty about the timing of the return of office employment. In the San Francisco panelists’ view, occupancy and inflation adjusted rental rates will be declining over the next three years and the panelists will be starting fewer projects than in the last 12 months.

In the East Bay, Sacramento, and San Joaquin markets, there is optimism on both rental rates and vacancy rates. This is due to the move to the suburbs by Bay Area households seeking lower housing costs and larger homes with ready access to San Francisco and Silicon Valley.

Each of the Southern California panels and the Silicon Valley panel expect rental growth to outpace inflation and vacancy rates to rise. These opposite trends drive the sentiment down from the previous survey with Los Angeles and the Inland Empire panels below the dividing line between positive and negative, and the Silicon Valley, Orange County, and San Diego panels above it. For each of these markets, this is a sign of very hot markets normalizing and not a sign of a downturn in these markets. Overall, we expect growth in multi-family housing development over the next three years with more of it backloaded until after a post-recession or post-recession-scare year of 2023.

There are two other factors driving new multi-family development in the 2023-2025 period. First, the inland parts of the state have been experiencing growth in logistics and infrastructure construction. Second, a series of state laws -- SB8, SB9 and SB10, and AB2011, AB2097 and AB2234 -- superseded some local building approval processes, opened land currently zoned for single-family homes to the construction of small multi-family structures, and have reduced barriers to multi-family construction in transit corridors. Early data indicate that these will be significant factors for the coming year as the latest permit numbers show an increase in new home construction in the early part of 2023.

Chart 5
Chart 6

“Everybody wants to build multi-family housing, especially in California, because there’s such a demand. We have such a lack of supply. As such, interest rates and inflation won’t create a huge impact on land use entitlements and development. The multi-family market is very hot right now.”

— Spencer Kallick, Partner, Allen Matkins

Retail Space Markets


Is retail poised to come back from the bottom of the cycle?  The totality of the recent Allen Matkins/UCLA Anderson Forecast Commercial Reale Estate surveys points to a recovery. Though developer/owner sentiment is mixed, particularly in Northern California, overall, the signs are positive, and the expectation is for a beginning of a new cycle in retail space by 2025 (Chart 7).

The sentiment index for San Francisco has trended upwards, yet it remains one of the more negative of the regions surveyed. This negative sentiment could well have been impacted by the timing of the Survey. An important development in the weeks after the Winter 2023 Survey closed was the unexpected ending of zero-COVID restrictions in China, including those requiring quarantine for travel. The end of pandemic restrictions elsewhere suggests a surge of Chinese tourists to San Francisco. Such a surge will drive a dramatic increase in retail demand, an increase that was not previously expected. Silicon Valley concerns are similar to those in San Francisco. Layoffs at large tech firms coupled with higher interest rates and recession worries turned sentiment negative after a year of optimism. This negative sentiment has more to do with uncertainty as payroll employment has continued to grow.

The Sacramento/San Joaquin region has been neutral on average. Certainly, work- from-home and hybrid work on the part of State Government has had an impact.  As Sacramento is the fastest growing large city in the state and commuter cities such as Lathrop and Tracy posting solid gains in new housing, the expectation is for sentiment to also become positive by next winter’s survey.

There are three forces at work that help create the overall optimism in other retail markets. First, a limited return to the office has increased the demand for retail in the core of these other California cities. To be sure, it is not back to where it was pre-pandemic, but the trend is in that direction. Second, the building of new housing throughout the state has created a demand for new retail close to that housing. Third, there is expected to be a demand for the reconfiguration of retail establishments to a more open-air post-COVID concept to attract consumers back to stores.

There are now solid targeted opportunities around the state, particularly where new housing developments are springing up. And despite a possible recession, planned housing construction will continue to generate new retail development demand over the coming 3 years.

Although the trends in the sentiment indexes are moving in the direction of a turnaround, the percentage of panelists in Southern California planning new developments over the next 12 months is significantly lower than the percentage that began new projects the previous 12 months. Similarly in Northern California, most developers remain on the sideline. Thus, new retail development in 2023 will be depressed, but the data are indicating a turnaround and a new retail building cycle beginning before the end of 2025.

Chart 7
Chart 8

“Retail fundamentals coming out of the pandemic have been incredibly strong. You had all that pent up demand of shoppers not being able to go out and spend money. If you’re a landlord or current retail owner, you’re benefiting from the increase in consumer spending.”

— El Warner, Vice Chair of Retail Capital Markets, Colliers

The Survey in Perspective


The Winter 2023 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey was taken as a new constellation of economic uncertainties was unfolding. Our Survey respondents were understandably more cautious about the coming 12 months with increased financing costs and the possibility of a 2023 recession. Nevertheless, industrial markets, which continue to experience historically low vacancy rates, remain poised for a good run of new building and superior returns. Multi-family housing has rapidly bounced back from a “falling-rent” hiatus and is also foreseeing new project development, particularly in 2024 and 2025.  With the current elevated uncertainty, the two sectors still adjusting to a post-COVID economic environment—office and retail—will take longer than previously predicted to begin their new development cycles.

“The latest survey shows that industrial continues to see historically low vacancy rates, multi-family remains generally optimistic though less so than previously forecast, retail continues its recovery from a low bottom and office shows a longer recovery time than previously predicted.”

— John Tipton, Partner, Allen Matkins

“The latest survey paints a relatively better picture for commercial real estate in California. This is particularly true for the period after 2023. Nevertheless, commercial real estate development in California is impacted by higher interest rates and the expected slower economic growth.”

— Jerry Nickelsburg, Director, UCLA Anderson Forecast